978-1305971509 Chapter 3 Lecture Notes

WHAT’S NEW IN THE EIGHTH EDITION:

There is a new Ask the Experts feature on “Trade Between China and the United States.”

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

how everyone can benet when people trade with one another.

the meaning of absolute advantage and comparative advantage.

how comparative advantage explains the gains from trade.

31

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3

INTERDEPENDENCE AND THE

GAINS FROM TRADE

32 ❖ Chapter 3/Interdependence and the Gains from Trade

how to apply the theory of comparative advantage to everyday life and national policy.

CONTEXT AND PURPOSE:

Chapter 3 is the third chapter in the three-chapter section that serves as the introduction of

the text. Chapter 1 introduced ten fundamental principles of economics. Chapter 2

developed how economists approach problems. This chapter shows how people and

countries gain from trade (which is one of the ten principles discussed in Chapter 1).

The purpose of Chapter 3 is to demonstrate how everyone can gain from trade. Trade

allows people to specialize in the production of goods for which they have a comparative

advantage and then trade for goods that other people produce. Because of specialization,

total output rises, and through trade we are all able to share in the bounty. This is as true for

countries as it is for individuals. Because everyone can gain from trade, restrictions on trade

tend to reduce welfare.

KEY POINTS:

Each person consumes goods and services produced by many other people both in the

United States and around the world. Interdependence and trade are desirable because

they allow everyone to enjoy a greater quantity and variety of goods and services.

There are two ways to compare the ability of two people to produce a good. The person

who can produce the good with a smaller quantity of inputs is said to have an absolute

advantage in producing the good. The person who has the smaller opportunity cost of

producing the good is said to have a comparative advantage. The gains from trade are

based on comparative advantage, not absolute advantage.

Trade makes everyone better o? because it allows people to specialize in those activities

in which they have a comparative advantage.

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Chapter 3/Interdependence and the Gains from Trade ❖ 33

The principle of comparative advantage applies to countries as well as to people.

Economists use the principle of comparative advantage to advocate free trade among

countries.

CHAPTER OUTLINE:

I. A Parable for the Modern Economy

A. Example: two goods—meat and potatoes; and two people—a cattle rancher named

Ruby and a potato farmer named Frank (each of whom likes to consume both

potatoes and meat).

1. The gains from trade are obvious if Frank can only grow potatoes and Ruby can

only raise cattle.

2. The gains from trade are also obvious if, instead, Frank can raise cattle as well as

grow potatoes, but he is not as good at it and Ruby can grow potatoes in addition

to raising cattle, but her land is not well suited for it.

3. The gains from trade are not as clear if either Frank or Ruby is better at producing

both potatoes and meat.

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Begin by explaining that there are two basic ways that individuals can

satisfy their wants. The rst is to be economically self-suCcient. The

second is to specialize in the production of one thing and then trade with

others. With rare exceptions, individuals and nations tend to rely on

specialization and trade. One way to demonstrate this is to survey the

students on their future plans (doctors, lawyers, teachers, etc.). Point out

34 ❖ Chapter 3/Interdependence and the Gains from Trade

Make sure that you write out all of the algebra involved in this example. If

you leave out steps, students will not understand how these calculations

are made.

B. Production Possibilities

1. Frank and Ruby both work eight hours per day and can use this time to grow

potatoes, raise cattle, or both.

2. Figure 1 shows the amount of time each takes to produce one ounce of either

good:

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Chapter 3/Interdependence and the Gains from Trade ❖ 35

Figure 1

Minutes Needed to

Make One Ounce of:

Amount Produced in Eight

Hours

Meat Potatoes Meat Potatoes

Frank the farmer 60

min./oz.

15 min./oz. 8/1=8 oz. 8/0.25=32 oz.

Ruby the rancher 20

min./oz.

10 min./oz. 8/0.33=24 oz. 8/0.16=48 oz.

ALTERNATIVE CLASSROOM EXAMPLE:

Martha and Stewart each spend eight hours a day wallpapering and painting:

Hours Needed to Do One

Room

Rooms Finished in 40 Hours

Paint Wallpaper Paint Wallpaper

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36 ❖ Chapter 3/Interdependence and the Gains from Trade

3. The production possibilities frontiers can also be drawn.

a. These production possibilities frontiers are drawn linearly instead of being

bowed out. This assumes that Frank’s and Ruby’s technology for producing

meat and potatoes allows them to switch between producing one good and

the other at a constant rate.

b. As we saw in Chapter 2, these production possibilities frontiers represent the

principles of trade-o?s and opportunity costs.

It is important to take the time to explain how to calculate the x– and

y-intercepts. Point out that Frank could produce 8 ounces of meat if all of

his time is spent on meat or 32 ounces of potatoes if all of his time is

4. We will assume that Frank and Ruby divide their time equally between raising

cattle and growing potatoes.

a. Frank produces (and consumes) at point A—16 ounces of potatoes and 4

ounces of meat.

b. Ruby produces (and consumes) at point B—24 ounces of potatoes and 12

ounces of meat.

You should emphasize that these production possibilities frontiers

represent the farmer’s and the rancher’s consumption possibilities

because we are assuming that there is no trade.

C. Specialization and Trade

1. Suppose Ruby suggests that Frank specialize in the production of potatoes and

then trade with her for meat.

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Chapter 3/Interdependence and the Gains from Trade ❖ 37

a. Ruby will spend six hours a day producing meat (18 ounces) and two hours a

week growing potatoes (12 ounces).

b. Frank will spend eight hours a day growing potatoes (32 ounces).

c. Ruby will trade 5 ounces of meat for 15 ounces of potatoes.

Students will ask how this “price” is determined. Explain the range of

prices that each participant would be willing to accept.

2. End results:

a. Ruby produces 18 ounces of meat and trades 5 ounces, leaving her with 13

ounces of meat. She also grows 12 ounces of potatoes and receives 15 ounces

in the trade, leaving her with 27 ounces of potatoes.

b. Frank produces 32 ounces of potatoes and trades 15 ounces, leaving him with

17 ounces. He also receives 5 ounces of meat in the trade with Ruby.

3. In both cases, they are able to consume quantities of potatoes and meat after the

trade that they could not reach before the trade.

Prove to your students that it would take each of them more than eight

hours to produce these quantities on their own.

Figure 2

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38 ❖ Chapter 3/Interdependence and the Gains from Trade

II. Comparative Advantage: The Driving Force of Specialization

A. Absolute Advantage

1. Denition of absolute advantage: the ability to produce a good using

fewer inputs than another producer does.

2. Ruby has an absolute advantage in the production of both potatoes and meat.

B. Opportunity Cost and Comparative Advantage

1. Denition of opportunity cost: whatever must be given up to obtain some

item.

Table 1

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Chapter 3/Interdependence and the Gains from Trade ❖ 39

a. For Ruby, it takes ten minutes to produce one ounce of potatoes. Those same

ten minutes could be used to produce one-half ounce of meat. Thus, the

opportunity cost of producing an ounce of potatoes is one-half ounce of meat.

b. For Frank, it takes 15 minutes to produce one ounce of potatoes. Those same

15 minutes could be used to produce one-fourth ounce of meat. Therefore,

the opportunity cost of producing one ounce of potatoes is one-fourth ounce

of meat.

c. The opportunity cost of producing one ounce of meat is the inverse of the

opportunity cost of producing one ounce of potatoes.

Your students may have a hard time comprehending this. Make sure that

you go through these calculations several times and write out every step.

2. Denition of comparative advantage: the ability to produce a good at a

lower opportunity cost than another producer.

a. Frank has a lower opportunity cost of producing potatoes and therefore has a

comparative advantage in the production of potatoes.

b. Ruby has a lower opportunity cost of producing meat and therefore has a

comparative advantage in the production of meat.

3. Because the opportunity cost of producing one good is the inverse of the

opportunity cost of producing the other, it is impossible for a person to have a

comparative advantage in the production of both goods.

C. Comparative Advantage and Trade

1. When specialization in a good occurs (assuming there is a comparative

advantage), total output will grow.

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40 ❖ Chapter 3/Interdependence and the Gains from Trade

2. As long as the opportunity cost of producing the goods di?ers across the two

individuals, both can gain from specialization and trade.

a. Frank buys 5 ounces of meat with 15 ounces of potatoes. This implies that the

price of each ounce of meat is three ounces of potatoes, which is lower than

Frank’s opportunity cost of four ounces of potatoes. Trade is benecial to

Frank.

b. Ruby buys 15 ounces of potatoes for 5 ounces of meat. The price of each

ounce of potatoes is one-third ounce of meat. This is lower than Ruby’s

opportunity cost of one-half ounce of meat. Trade also benets Ruby.

D. The Price of the Trade

1. For both parties to gain from trade, the price at which they trade must lie

between the opportunity costs.

2. In our example, Frank and Ruby must trade at the rate of between 2 and 4 ounces

of potatoes for each of meat.

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Chapter 3/Interdependence and the Gains from Trade ❖ 41

Activity 1—Creating Comparative Advantage Examples

Type: In-Class Assignment

Topics: Specialization, interdependence, self-interest, comparative

advantage

Materials needed: 3-5 candy bars (or similar items to use as prizes)

Time: 15 minutes (rst day), depends on number of groups

(second day)

Class limitations: works in any size class

Purpose

This assignment allows students to further explore comparative advantage.

Instructions

Divide the class into groups of three or four to write a comparative advantage

problem of their own. Tell them to make creative, humorous, yet plausible

examples.

E. FYI: The Legacy of Adam Smith and David Ricardo

1. In Adam Smith’s 1776 book An Inquiry into the Nature and Causes of the Wealth

of Nations, he writes of the ability of producers to benet through specialization

and trade.

2. In David Ricardo’s 1817 book Principles of Political Economy and Taxation, Ricardo

develops the theory of comparative advantage and argues against restrictions on

free trade.

3. The benets of free trade are an issue that is generally agreed upon by most

economists, and the theories and arguments developed by these two individuals

200 years ago are still used today.

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42 ❖ Chapter 3/Interdependence and the Gains from Trade

IV. Applications of Comparative Advantage

A. Should Serena Williams Mow Her Own Lawn?

1. Imagine that Serena can mow her lawn faster than anyone else can.

2. This implies that she has an absolute advantage.

3. Suppose that it takes her two hours to mow her lawn. In that same two hours, she

could lm a commercial for which she would earn $30,000. This means that the

opportunity cost of mowing her lawn is $30,000.

4. It is likely that someone else would have a lower opportunity cost of mowing

Serena’s lawn; this individual would have a comparative advantage.

5. Both she and the person hired will be better o? as long as she pays the individual

more than the individual’s opportunity cost and less than $30,000.

B. In the News: Economics within a Marriage

1. The principles of comparative advantage and gains from specialization and trade

even apply to housework.

2. This article from Slate describes the division of housework between the author

and her husband, even though she has the absolute advantage in doing it all.

C. Should the United States Trade with Other Countries?

1. Just as individuals can benet from specialization and trade, so can the

populations of di?erent countries.

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Chapter 3/Interdependence and the Gains from Trade ❖ 43

2. Denition of imports: goods produced abroad and sold domestically.

3. Denition of exports: goods produced domestically and sold abroad.

4. The principle of comparative advantage suggests that each good should be

produced by the country with a comparative advantage in producing that good

(smaller opportunity cost).

5. Through specialization and trade, countries can have more of all goods to

consume.

6. Trade issues among nations are more complex. Some individuals can be made

worse o? even when the country as a whole is made better o?.

D. Ask the Experts: Trade Between China and the United States

1. 100 percent of economic expert surveyed agreed that trade with China makes

most Americans better o?.

2. 96 percent of economic experts surveyed agreed that some Americans who work

in the production of competing goods are made worse o? by trade with China.

To help students reconcile these two survey results, point out that trade

makes most Americans better o? and only makes a small group of

Americans worse o?.

To help convince students that importing goods is not harmful to a

country, ask the students to devise a way to produce co?ee domestically.

Point out that it is possible to grow co?ee beans in the United States in

enclosed nurseries, but the opportunity cost of the resources used would

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44 ❖ Chapter 3/Interdependence and the Gains from Trade

Discuss how di?erences in resource endowments can be signicant

factors in determining opportunity cost and comparative advantage. Such

di?erences include climate, soil composition, education and training of the

labor force, capital stock, and infrastructure.

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